Hey, Everyone, The Great Bond Bull Market Is Finally Toast

EQUITIES may be enjoying a bull run but the government-bond
market has turned sour.

Having bottomed at 1.67% in September, the yield on the ten-year
Treasury bond has risen to 2.38%, with the sell-off accelerating
in the past two weeks.

A rise in yields from what were very low levels, in historical
terms, is not that surprising. The economic data have been better
than expected since the start of the year, particularly in
America, calming fears of a global recession. A torrent of
central-bank loans to euro-zone banks and Greece’s
debt-restructuring deal have made investors less nervous about a
break-up of the euro, removing the appeal of Treasury bonds as a
haven.

The big question is whether this is a turning-point in the bond
market. The chart shows how the rise and fall of Treasury-bond
yields over the past century-and-a-bit divides into very long
phases. Chris Watling of Longview Economics points out there has
been a remarkable regularity to the past three cycles—a 29-year
downtrend, followed by a 32-year uptrend and another 31-year
downtrend lasting to the present. This pattern is probably a
coincidence but it does illustrate that bond-market cycles are
rather longer than those in the equity market. Mr Watling points
out that the early stages of bond cycles (1920-29, 1949-68 and
1982-2000) have been associated with equity bull markets while
the latter stages (1929-49, 1968-82 and 2000 to date) have been
associated with bear phases.

The big bear markets in bonds were associated with higher
inflation. There was a brief inflationary period associated with
the first world war and a much longer burst of rising prices
after the second world war which culminated in the 1970s. Some
fear the inevitable response to the current crisis is that
countries will attempt to inflate away their debt.

But there is not much sign of this in the consumer-price indices.
Inflation is expected to average 2-2.5% this year in America,
Britain and the euro zone. And bond investors do not seem to be
too concerned about the near future, to judge by the breakeven
inflation rates (the gap between the yield on conventional and
inflation-linked bonds). These reached a nadir of just under 1.5%
(for five-year bonds) in September and are now up to 2.1%; for
ten-year bonds, there has been a move from 1.7% to 2.4%. But
those rates are still consistent with central-bank inflation
targets.

There is a problem, however, with using market numbers to divine
the mood of private-sector investors: central banks have been
intervening heavily in the bond markets at both ends of the yield
curve. Charles Kindleberger, a financial historian, long ago
established that credit creation was a key component of bubbles.
You cannot always tell where the bubble will emerge but central
banks have given a big hint this time by buying the asset
directly.

The policy is designed to revive the economy but the effect on
investors, many of which are forced by regulations to hold
government bonds, has been dubbed “financial repression”. By
keeping rates low at a time of massive fiscal deficits, central
banks are also reducing the pressure on governments to get their
finances in order. “When a central bank actively seeks to keep
yields below inflation in order to generate negative real
interest rates, by implication it is imposing negative real
returns on investors,” says Hans Lorenzen of Citigroup. “In so
doing, it is ensuring that the sovereign can borrow cheaply.”

Another worry is how governments and central banks can return
policy to a pre-crisis setting. In Europe attempts at fiscal
austerity have been followed by deep recessions. Can central
banks raise interest rates to normal levels of 3-4% without
causing widespread bankruptcies? Can they withdraw liquidity
support from commercial banks without causing a financial crisis?
And can they offload their government-bond holdings without
causing a very sharp rise in yields?

Given these risks, it is not difficult to construct a bearish
scenario for bonds. Indeed,
central banks were also holding short rates at very low levels at
the last nadir for bond yields in the late 1940s (a moment when,
as now, governments were trying to deal with accumulated debts).

But even if bond yields have touched the bottom for this long
cycle, it is worth remembering that the period of low yields in
the 1940s was quite protracted, lasting eight years or so. In the
short term, if yields were to rise too far, to 3% or so, central
banks could always step in with another round of quantitative
easing. The great bear market in bonds may have begun but the
decline will not necessarily be precipitous.